7 Financial Statements subheading. Figure 2-1 is an example of a typical Income Statement. Even though such rules seem silly, and for the most part are not very important as long as it is obvious to the reader how to interpret the information, they do serve a purpose. The double underline tells the reader what the final total of the statement is. The single underline alerts the reader that a sub- total is coming on the next line. Indenting is an efficient way of depicting a grouping of like items. Statement of Retained Earnings The Statement of Retained Earnings takes the beginning bal- ance of Retained earnings (which is the same as the ending FIGURE 2-1 Jeffry Haber Company Income Statement For the Year Ended December 31, 2002 Revenues: Sales $250,000 Interest income 500 Total revenue $250,500 Expenses: Payroll $125,000 Payroll taxes 20,000 Rent 10,000 Telephone 7,000 Office supplies 3,000 Total expenses $165,000 Net income $ 85,500 10288$ $CH2 08-29-03 08:31:03 PS 8 Accounting Demystified balance from the previous period), then adds net income and subtracts dividends paid to stockholders to arrive at the ending balance of Retained earnings. Dividends are distributions of money to shareholders. The Statement of Retained Earnings is for a period of time, and the period should be the same as that of the Income Statement. A dollar sign ($) is used for the first and last numbers, and the last number is double-underlined. Some people like to use a subtotal after net income, but this is not required. A sample Statement of Retained Earnings is given in Figure 2-2. Note that the net income amount is the same as the net income shown on the Income Statement. The financial state- ments are related to one another, and at times, a figure from one statement is carried over to another statement. Balance Sheet The Balance Sheet lists the assets, liabilities, and equity ac- counts of the company. The Balance Sheet is prepared ‘‘as on’’ a particular day, and the accounts reflect the balances that ex- isted at the close of business on that day. The Balance Sheet is FIGURE 2-2 Jeffry Haber Company Statement of Retained Earnings For the Year Ended December 31, 2002 Beginning balance, January 1, 2002 $100,000 Add: Net income 85,500 Less: Dividends 35,500 Ending balance, December 31, 2002 $150,000 10288$ $CH2 08-29-03 08:31:03 PS 9 Financial Statements prepared on the last day that the Income Statement covers, so if the Income Statement is for the period ending December 31, 2002, the Balance Sheet would be as on December 31, 2002. You can state the date in a variety of formats. All of the follow- ing are acceptable: As on December 31, 2002 December 31, 2002 On December 31, 2002 The following are typical accounts that are classified as assets, liabilities, and equity accounts. (These accounts are de- fined later on in the book. There is no reason why you need to know the definitions at this point, but if you are curious, you can turn to the glossary.) Assets Liabilities Equity Cash Accounts payable Common stock Accounts receivable Salaries payable Paid-in capital Prepaid expenses Taxes payable Retained earnings Inventory Unearned revenue Land Notes payable Building Bonds payable Equipment Mortgage payable Vehicles A good general rule of thumb is that any account that has the word receivable in its title will be an asset, and any account that has the word payable in its title will be a liability. Any account that has the word expense in its title is likely to be classified as an expense on the Income Statement, except for 10288$ $CH2 08-29-03 08:31:03 PS 10 Accounting Demystified the account Prepaid expenses, which is an asset. Any account with the word income or revenue in its title is classified as reve- nue on the Income Statement, except for the account Un- earned revenue, which is a liability. A sample Balance Sheet is shown in Figure 2-3. On the Balance Sheet, the largest numbers in each section are not necessarily listed first. On the asset side of the Balance Sheet, the accounts are listed in order of their liquidity. Liquid- ity means nearness to cash. Cash is listed first, since cash is already cash. Each current asset is then listed in the order in which it is expected to become cash. Accounts receivable FIGURE 2-3 Jeffry Haber Company Balance Sheet December 31, 2002 Assets: Cash $ 75,000 Accounts receivable 25,000 Inventory 200,000 Prepaid expenses 50,000 Total Assets $350,000 Liabilities: Accounts payable $50,000 Salaries payable 75,000 Notes payable 65,000 Total Liabilities $190,000 Stockholders’ Equity: Common stock $ 10,000 Retained earnings 150,000 Total Stockholder’s Equity $160,000 Total Liabilities and Stockholder’s Equity $350,000 10288$ $CH2 08-29-03 08:31:03 PS 11 Financial Statements comes second, since this company believes that its accounts receivable will be collected prior to the other assets being turned into cash. On the liability side, the accounts are listed in the order in which they are expected to be satisfied (a fancy way of saying paid). The order of the equity accounts is defined by custom and tradition. There is a special type of Balance Sheet called a classified Balance Sheet. In a classified Balance Sheet, the assets are sep- arated into current and noncurrent (or long-term; the names noncurrent and long-term are synonymous in accounting) assets, and the liabilities are similarly classified as current and noncurrent. Included in the current section of the assets are those assets that are expected to be turned into cash or used up within the next year. Assets that are not expected to be turned into cash or used up within the next year are classified as noncurrent. Current liabilities are those liabilities that are expected to be paid during the next year. Noncurrent liabilities are those liabilities that are expected to be paid sometime after next year. We have talked about three of the statements (the Income Statement, the Statement of Retained Earnings, and the Bal- ance Sheet). Which statement do you prepare first? This is strictly a matter of preference; however, as a general rule, it makes the most sense to prepare the Income Statement first, then the Statement of Retained Earnings, and then the Balance Sheet. (The Statement of Cash Flows will be dealt with in a later chapter and is not discussed here.) Why does that order make sense? To complete the Balance Sheet, the ending amount of Retained earnings is needed. This number comes from the Statement of Retained Earnings, so it makes sense to prepare the Statement of Retained Earnings 10288$ $CH2 08-29-03 08:31:03 PS 12 Accounting Demystified prior to preparing the Balance Sheet. In order to complete the Statement of Retained Earnings, the amount of net income is required, and this comes from the Income Statement. There- fore, it makes sense to prepare the Income Statement prior to preparing the Statement of Retained Earnings. Income Statement Net Income Statement of Retained Earnings Ending Balance of Retained Earnings Balance Sheet Thus, while the statements may be prepared in any order, if you prepare them in a different sequence, you will not be able to finish the statement you are working on without stop- ping and going to work on another statement. Eventually they will all be completed, but it will involve some jumping around. Summary This chapter covered the end result of financial accounting, the preparation of financial statements. Now we jump back to the beginning of the accounting process and look at how the information gets recorded in order to be available to be put on the financial statements. 10288$ $CH2 08-29-03 08:31:04 PS CHAPTER 3 The Accounting Process We started with the end product of the accounting process, the financial statements. The steps involved in getting to the financial statements are: Journalize Post Trial balance Adjustments Financial statements Close These steps include some words we haven’t used before. They will be explained later in the chapter. 13 10288$ $CH3 08-29-03 08:31:04 PS 14 Accounting Demystified Journalize Journalizing is the process of taking transactions and turning them into a form (a journal entry) that can be captured by the financial accounting system. Not everything that happens in the course of a business day requires that a journal entry be made. If you get a letter from a customer praising your prod- uct, no journal entry is required. If a customer calls and asks your hours of operation, no journal entry is required. A journal entry is required only when there is a change in an account balance. With the journal entry, we get into debits and credits. Deb- its and credits are the left-hand and right-hand sides of a jour- nal entry. They are also a standard shorthand way of saying whether we are increasing or decreasing the balance in an ac- count. In making a journal entry, it is standard practice to list the account(s) getting the debit first and the account(s) getting the credit second. It is also standard to offset the credit entry a little to the right. In addition, it is common to give the date of the transaction and a short description explaining why the entry is being made. A standard journal entry in which we are increasing (debiting) Cash and increasing (crediting) Sales would be: XX/XX/XX Cash 10,000 Sales 10,000 To record cash sales (Whenever you see the notation ‘‘XX/XX/XX,’’ it means that a date would typically be included.) The sample journal entry provides a debit to Cash (which will increase the balance of the Cash account) and a credit to 10288$ $CH3 08-29-03 08:31:04 PS 15 The Accounting Process Sales (which will increase the balance of the Sales account). How do we know when debits will increase or decrease an ac- count? We know the effect debits and credits have from the accounting equation. The Accounting Equation The accounting equation is the algebraic formula: Assets ס Liabilities ם Equity You may recognize the terms assets, liabilities, and equity from the Balance Sheet. Remember that on the Balance Sheet, the asset section total was equal to the sum of the liability and equity section totals. This is the accounting equation. From the Balance Sheet, we know that the components of equity are Common stock and Retained earnings. Thus, we can replace equity in the accounting equation with Common stock and Retained earnings: Assets ס Liabilities ם Common stock ם Retained earnings From the Statement of Retained Earnings, we know that ending Retained earnings are equal to beginning Retained earnings plus net income minus dividends. We can therefore replace Retained earnings with these accounts in the equation: Assets ס Liabilities ם Common stock ם Beginning retained earnings ם Net income מ Dividends From the Income Statement, we know that net income is equal to revenues minus expenses. Thus, we can replace net 10288$ $CH3 08-29-03 08:31:05 PS 16 Accounting Demystified income in the equation with revenues minus expenses. After doing this, the equation becomes: Assets ס Liabilities ם Common stock ם Beginning retained earnings ם Revenues מ Expenses מ Dividends Since this is an algebraic equation, we can take the items that are subtracted and move them from the right side of the equation to the left side: Assets ם Expenses ם Dividends ס Liabilities ם Common stock ם Beginning retained earnings ם Revenues The reason we went through these steps to get the ac- counting equation in this form is to be able to explain the ef- fect of debits and credits on the various accounts (see Figure 3-1). For the accounts to the left of the equal sign (assets, ex- penses, and dividends), debits will increase the balance and credits will decrease the balance. For the accounts to the right of the equal sign (liabilities, common stock, beginning re- tained earnings, and revenues), debits will decrease the bal- ance and credits will increase the balance. FIGURE 3-1 Liabilities, Common Stock, Beginning Retained Earnings, Assets, Expenses, Dividends Revenues םממם 10288$ $CH3 08-29-03 08:31:05 PS [...]... we get after we divide by 9 provides a lot of 21 The Accounting Process FIGURE 3-7 Jeffry Haber Company Trial Balance For the Year Ended December 31, 20 02 Debits Sales 25 0,000 Interest income Payroll Credits 500 125 ,000 Payroll taxes 20 ,000 Rent 10,000 Telephone 7,000 Office supplies 3,000 Cash 75,000 Accounts receivable 25 ,000 Inventory Prepaid expenses 20 0,000 50,000 Accounts payable 50,000 Salaries... Cash account had debits of $10,000, $20 ,000, and $5,000 and there was one credit of $15,000, the account would have a debit balance of $20 ,000 [The total debits are $10,000 ‫ ,000,53$ ס 000,5$ ם 000, 02$ ם‬and the FIGURE 3 -2 Cash 10,000 18 Accounting Demystified FIGURE 3-3 Sales 10,000 total credits are $15,000 Subtracting the total debits and total credits produces $20 ,000 ($35,000 ‫ ,)000,51$ מ‬which... credits You prepare the trial balance by going through the general ledger, taking the balance from each FIGURE 3-6 Cash Date Debit 7/01/01 10,000 10,000 7/ 02/ 01 20 ,000 30,000 7/14/01 7/15/01 Credit 15,000 5,000 Balance 15,000 20 ,000 20 Accounting Demystified page (with each page being a different account), and listing those balances When you are finished, you total the debits column and then total the... Retained earnings Dividends Total 100,000 35,500 550,500 550,500 22 Accounting Demystified information about the potential error we are looking for Since our number after dividing was 1,000, if the error is a transposition, we are looking for a transposition in which the numbers that were flipped are consecutive (for example, flipping 1 and 2, 2 and 3, 3 and 4, and so on) That is the information contained... name of the account, debits in a column on the left, and credits in a column on the right There can be additional columns FIGURE 3-4 Cash 10,000 20 ,000 5,000 20 ,000 15,000 19 The Accounting Process FIGURE 3-5 Cash 10,000 20 ,000 5,000 15,000 35,000 15,000 20 ,000 for a running balance (see Figure 3-6), or the balance can be written under the larger side The basics of the T account are applicable to any... for is entering the amount in the wrong column If we take the difference and divide it by 2, we get 500 (1,000 /2) Now we scan the trial balance looking for an amount of 500 The only account that meets this criterion is Interest income We check the general ledger and find that the amount The Accounting Process 23 should be in the credit column, but we mistakenly put it in the debit column Problem solved... Income Statement first, and this lets them start at the top of the trial balance and work their way through the financial statements 24 Accounting Demystified Rest of the Process Adjusting entries and closing entries will be covered in Chapter 18 The next step in learning financial accounting is to learn the actual recording of transactions We get information into the general ledger by journalizing transactions... we first divide the difference by 9 The difference does not divide evenly by 9, so this is not a transposition error We then take the difference and divide it in half, giving a result of 25 ,000 There is no amount of 25 ,000 in the trial balance, so we did not enter an amount in the wrong column We then go back to the general ledger and look for an account with a balance of 50,000 We see that Accounts... and 2, 2 and 3, 3 and 4, and so on) That is the information contained in the first digit If the first digit of the number we got after dividing was 2, then we would be looking for a transposition involving numbers that were two places away (for example, 1 and 3, 2 and 4, 3 and 5, and so on) The number of zeros provides information about which digits were transposed (if this is a transposition error) Since... critical step The financial statements will be only as good as the information they contain Summary This chapter described the accounting process and discussed each step from the point at which a journal entry is made through the trial balance The chapter also explained the accounting equation and expanded the equation to provide a framework for understanding when debits and credits increase or decrease . 31, 20 02, the Balance Sheet would be as on December 31, 20 02. You can state the date in a variety of formats. All of the follow- ing are acceptable: As on December 31, 20 02 December 31, 20 02 On. Credit Balance 7/01/01 10,000 10,000 7/ 02/ 01 20 ,000 30,000 7/14/01 15,000 15,000 7/15/01 5,000 20 ,000 1 028 8$ $CH3 08 -29 -03 08:31:06 PS 20 Accounting Demystified page (with each page being a different. columns FIGURE 3-4 Cash 10,000 15,000 20 ,000 5,000 20 ,000 1 028 8$ $CH3 08 -29 -03 08:31:06 PS 19 The Accounting Process FIGURE 3-5 Cash 10,000 15,000 20 ,000 5,000 35,000 15,000 20 ,000 for a running balance